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Macroeconomic and regulatory considerations of fixed income country classification

August 31, 2018

By Scott Harman and Nikki Stefanelli

In our previous blog we noted the long-established process for determining the classification of equity markets and how the rigor, transparency and evidence-driven nature of that framework can be effectively applied, with sensible adjustments, to the fixed income index world. Additionally, we highlighted the nuances of fixed income markets, which now raise the fundamental question for a multi-asset index provider such as FTSE Russell: What really matters for index users when evaluating local market eligibility for inclusion in broad-based global fixed income benchmarks?

As indexing becomes more prevalent and the global debt markets become more open, we believe it is critical for administrators of fixed income benchmarks to provide a comprehensive and transparent framework for evaluating market accessibility using key variables that matter to index users. FTSE Russell is currently engaging with index users to solicit feedback on our proposed Fixed Income Country Classification Framework, which will be formally adopted later this year. This is the first in a series of blog posts that will delve into our rationale for including the variables we did and why we believe they are particularly helpful in gauging relative market accessibility levels. Click here to review our consultation.

The first of four broad categories we propose using to assign a Market Accessibility Level is Market, Macroeconomic and Regulatory Environment, which includes as one of its variables, “transparent and open monetary policy framework”. We recognize that this particular criterion could possibly be less intuitive than the other more self-evident factors, such as investment restrictions and quotas that are explicitly designed to regulate foreign capital inflows and therefore thwart accessibility. In many “crossover markets”[1], monetary policy framework is still evolving but the increasing trend of these markets to be considered for inclusion in high-grade global fixed income indexes has raised the question of whether a transparent and well-articulated monetary policy framework is important for investors…

A considerable portion of the FTSE World Government Bond Index (WGBI) universe, for example, is comprised of mature bond markets that benefit from a transparent and well articulated monetary policy communicated by well established central banks, such as the Bank of England, the Federal Reserve, Bank of Japan and the European Central Bank. The combined market value of their respective government bond markets account for 93.1% of the WGBI as of July.[2]

Contrastingly, from the point of view of foreign investment (see the chart below for foreign ownership levels of select government bond markets), in China’s relatively less established government bond market, monetary policy communication appears less clear compared with other major central banks. While there has been significant progress in liberalizing the local bond market, China’s monetary policy framework is often criticized for a lack of clarity in the government’s operational targets, such as the key policy interest rate of the People’s Bank of China (PBoC). Moreover, the PBoC has exhibited a propensity to adjust policy rates and parameters, such as the reserve requirement ratio, outside of the scheduled quarterly monetary policy committee meetings. This is inconsistent with the more formal cycle of communication and decision making employed by central banks in other major government bond market.

Another recent example of a less evolved policy framework is that of Turkey where the central bank’s freedom to take more determined and aggressive measures, such as explicitly raising the base rate to tame inflation, have been restricted by the political demands of the Turkish government. President Erdogan’s opposition to rate increases has forced Turkey’s central bank to use more unconventional methods, which are unlikely to improve investors’ confidence. Whilst Turkey’s credit rating and market size do not meet eligibility criteria for the WGBI, it remains a core component of EM local currency government bond portfolios. The examples of Turkey and China serve to illustrate that the opaque monetary policy framework of certain EM government can pose questions about the suitability of such markets for inclusion in global fixed income benchmarks.

Finally, purely from an academic perspective, according to the expectations hypothesis theory on the term structure of interest rates, the long term rate of interest is determined by current and future expected short-term rates, ceteris paribus. Given the importance of monetary policy on interest rate expectations, it should follow that a government’s framework is relevant to the inclusion of its debt in fixed income benchmarks.

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[1] Credit quality in fixed income tends to supersede formal EM definitions, creating what are commonly referred to as “crossover markets” within flagship investment grade, multi-currency benchmarks for global portfolios. Benchmarks such as the FTSE World Government Bond Index (WGBI) are comprised of high credit quality government bond markets, generally considered developed, but also overlap with dedicated emerging markets benchmarks such as the FTSE Emerging Markets Government Bond Index (EMGBI) creating such “crossover markets” as Mexico and South Africa.

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